The Diminishing Future of Investment Advice Regulation

If you didn’t read through my summaries of the SEC’s new proposals, well, I don’t blame you; the proposals total more than 900 pages, and even the professionals haven’t read through all of it.  My summaries tried to tame the task a bit and make it easy for you to understand what was said, but of course that took more than 50 pages.  (To find them, just scroll backwards from this post.)

The gist of it is that the broker-dealers and sales agents are going to be held to a “best interest” standard that seems to be exactly what the “suitability” standard has always been, except the now the brokerage firms have a great new marketing term for it which makes their sales agents look, to the public, like they have to put the interests of their customers first.

Meanwhile, the SEC would force sales agents and brokers, on the one hand, and fiduciary advisors, on the other, to use its own language in a 4-page disclosure document that you provide to clients.  Among other things, you are required to tell clients that, since you don’t do a lot of trading in their accounts, they might be better off, financially, just paying for transactions in a brokerage account.  And, of course, you are required to disclose your AUM fee structure.

This got me thinking about the whole point of this effort by the SEC, and what I think will be the endgame. 

In retrospect, it seems clear that the whole regulatory structure got off the rails back in the middle 1970s.  Before that, a “commission” was something you paid in order to execute a trade—just like the transaction fees that the custodians charge to your clients whenever you trade one mutual fund for another or add new money to a fund or ETF position.

But sometime after 1975, when these trading commissions became negotiable, the idea of a “commission” morphed into something else, something closer to a bribe.  Commissions became a way for product companies to pay a broker or sales agent to recommend their products over products which offered superior features or returns. 

Think of how important was this shift.  Suddenly, in a crowded, competitive marketplace, these companies no longer had to compete on merit.  Instead, they could choose to compete on the much easier-to-navigate commission structure—on how much they were willing to pay brokers and sales agents to turn their heads away from investments that made the most sense for consumers, and recommend what put the most money in their own pocket instead.

I don’t think the framers of the 1940 Act envisioned this transition in the broker’s or sales agent’s role in the marketplace.  What followed was the limited partnership debacle, where what I consider to be criminal organizations (I was there) raised billions of dollars by paying out millions of dollars to sales agents, and then basically absconded with investors’ retirement savings.  Load mutual funds, meanwhile, collected hefty annual expense ratios after paying brokers and sales agents to recommend their shares. 

The incentive trips and sales contests, the payout grid where you earned higher percentages of commissions the more you sold, the revenue sharing arrangements and favorable payouts for proprietary products etc. were all designed to make the process of getting the public to buy bad products at a premium more attractive and efficient.

Even worse, a whole generation of brokers were told to stop analyzing what they recommended and just, for god sakes, sell already.  So many brokers were trying to parse through the (usually nonexistent) benefits of the products on the shelf, that the industry had to hire motivational speakers like Nick Murray to tell them that their job was emotional, rather than analytical.  I still remember his most famous line, offered with exasperation: “You don’t have to know how a watch is made to sell a watch.”  Words to live by for a true professional.

In retrospect, the SEC has proven to be a terrible regulator of this new commission regime.  The limited partnership industry was a transparent ruse to scam investors out of their money, and the non-traded REIT industry is, in my mind, simply limited partnerships redux.  Where was the SEC when Wall Street created a trillion-dollar market for derivatives and packaged mortgages, some of which were designed to fail while virtually all the others were marketed under false pretenses?  Today, brokerage firms routinely dump unwanted stocks from their own account into customer portfolios, and collect “revenue sharing” fees in return for shelf space—and otherwise restrict what brokers are allowed to recommend. 

With these new proposals, the SEC is fecklessly trying to, at the same time, restore merit-based investment recommendations to the marketplace and make Wall Street lobbyists happy.  During the comment period, there may be ways to improve the disclosures and put at least SOME teeth into the new best-interest standard, but these will be changes at the margins, and I predict they won’t be very meaningful.  Wall Street simply won’t allow it.

But at the same time, I can envision fiduciary planners responding in ways that turn these new disclosures back against the sales agents.  In the disclosure of AUM fees, I expect to see financial planners create a fee structure where the client’s cost for receiving investment advice is $0.

That is not a typo.  The value and complexity of managing client portfolios was considerable back in the 1970s and 1980s, and not inconsiderable in the 1990s and 2000s.  Today, in the 2010s, where clients can be matched with model portfolios by online algorithms, where rebalancing can be done automatically, and (soon) tax loss harvesting will be handled by machines, your (considerable) value to the client lies elsewhere.

Today, the only investment advice a client-facing advisor truly needs to provide to clients is this: “We need to diversify your investments, capture the opportunity set at the lowest possible cost, maybe try to catch a little alpha on the side (or not) and hang on tight no matter what the markets do.”  That’s it.  You shouldn’t have to charge a great deal for uttering that sentence.

Meanwhile, you deliver a great deal of value on the financial planning side, modeling a client’s financial future, looking for things to do today to improve it, helping clients identify clearer goals, navigating the tax code and responding to life emergencies.  The percentage attributable to financial planning, for many firms, is already 100%, and it is nearly so for many others.  The SEC doesn’t regulate planning advice or require disclosure on how much you charge for it.

Years ago, advisors charged for asset management and threw in financial planning services.  Now we are entering the era where that is exactly reversed.

So the brokerage firm lists its AUM or estimated commission costs, and the prospect is mulling them over as she sits down with you.  You provide your own disclosure form, and you aren’t charging for the asset management.  Or you’re charging very little, maybe 25 basis points, or you’re charging a flat quarterly fee that covers all of your services, and the asset management services are assigned a $1,000 a year flat fee for setup and maintenance costs, plus passing on the trading and custodial costs.

Eventually, I believe the commission regime will be chased away by the efficiency of online portfolio management plus the accommodation management of assets by financial planners.  The SEC’s disclosures, meanwhile, will accelerate what has been a very slow trend away from AUM toward more precise fee structures that offer consumers more choice in what services they buy and how much they pay. 

The outcome is a win-win for everybody except the companies that would never be able to get anybody to recommend their products unless they paid them handsomely to hold their nose and look the other way.